Edited version of private advice

Authorisation Number: 1052136159090

Date of advice: 5 July 2023

Ruling

Subject: Division 7A debt forgiveness

Question

Will subsection 109G(4) of the Income Tax Assessment Act 1936 (ITAA 1936) apply, so that any forgiveness of a debt owed by an entity to the company will not be deemed a dividend under Division 7A of the ITAA 1936?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 2021

The scheme commenced on:

7 August 2019

Relevant facts and circumstances

You are the sole director and shareholder of a company.

The company owned a property.

The property was originally purchased using a combination of money lent by you and a financial institution.

In accordance with specified agreements at a specified date the property was transferred to you.

The transfer of the property was completed at a specified date.

Prior to the transfer another entity was renting the property from the company.

When the property was transferred into your name you immediately moved in.

The value of the property at the time of the transfer was $XXX.

The mortgages totalling $XXX were refinanced into your name.

The property transfer combined with other transactions on the same date as the transfer resulted in a debt owed by you to the company.

The debt as at a specified date was $XXX.

The property was sold at a specified date for $XXX.

You used the proceeds from the sale to pay out other debt.

Your application stated the company wishes to forgive the debt subject to the Commissioner exercising his discretion under subsection 109G(4) as the company had assessed it would result in undue hardship for you and you are unable to service the debt owed by you to the company in addition to the bank mortgage.

In support of your application, you provided various material to show your loan servicing abilities.

The material of a specified earlier year included rental income from the property and a corresponding negative gearing tax effect.

The material of a specified later year did not include any existing rental income or corresponding negative gearing tax effect.

You have not reported any rental income in any of the relevant income years.

You provided an unsigned Deed of Forgiveness.

You provided a signed Division 7A loan agreement.

You stated various factors greatly diminished your financial resources and income earning capabilities

You stated the various factors reduced your financial capital and it meant you could no longer receive rental income as you needed somewhere to live, and you no longer had the same income earning capacity.

You are currently residing at a specified location.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 109F(1)

Income Tax Assessment Act 1936 subsection 109G(4)

Reasons for decision

Under Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936) amounts paid, lent or forgiven by a private company to certain associated entities are treated as dividends, unless they come within specific exclusions.

The provisions apply where the recipient of the payment, loan or forgiven amount is a shareholder or an associate of a shareholder of the private company.

Under subsection 109F(1) of the ITAA 1936 a private company is taken to pay a dividend to an entity (being a shareholder of or associate of a shareholder of the company) at the end of its year of income if all or part of a debt owed by the entity to the company is forgiven in that year.

The amount of the dividend equals the amount of the debt forgiven, subject to section 109Y of the ITAA 1936. However subsection 109G(4) of the ITAA 1936 provides that a private company will not be taken to pay a dividend in such circumstances if:

a) the debt was forgiven because payment of the debt would have caused the entity undue hardship; and

b) when the entity incurred the debt, the entity had the capacity to pay the debt; and

c) the entity lost the ability to pay the debt in the foreseeable future as a result of circumstances beyond the entity's control.

Each criterion will be addressed separately below.

a) payment of the debt would have caused the entity undue hardship

The phrase "undue hardship" is not defined in the ITAA 1936 and has not received judicial consideration in the context of Division 7A. Accordingly, it should be interpreted by having regard to its ordinary meaning, the statutory context in which the phrase appears and the object of the provision.

The Macquarie Dictionary defines hardship as:

A condition that bears hard upon one; severe, toil, trial, oppression or need.

In Re Wilson and Minister for Territories (1985) 7 ALD 225, the Administrative Appeals Tribunal considered the ordinary meaning of 'undue hardship'. Deputy President Hall described 'undue hardship' as hardship that is excessive in the circumstances, and something more than substantial hardship. This has been followed in subsequent decisions.

In the context of subsection 109G(4) of the ITAA 1936, hardship would necessarily involve a financial detriment resulting from the payment of the debt.

While the phrase "undue hardship" is not defined in the ITAA 1936 or other ATO publications, Practice Statement Law Administration PSLA 2011/17: Debt relief, waiver and non-pursuit (PSLA 2011/17) contains the following definition of the phrase "serious hardship":

8. Definition of serious hardship

'Serious hardship' is given its ordinary meaning.

We consider serious hardship to exist where the payment of a tax liability would result in a person being left without the means to afford basics such as food, clothing, medical supplies, accommodation or reasonable education.

We have tests to apply in helping you decide whether serious hardship exists. The object of the tests is to determine whether the consequences of paying the tax would be so burdensome that the person would be deprived of what are considered necessities according to normal community standards.

These tests are:

•         the income/outgoings test

•         the assets/liabilities test

•         other relevant factors.

Also, the phrase "serious financial hardship" is explained in Practice Statement Law Administration PSLA 2011/4: Collection and recovery of disputed debts (PSLA 2011/4) as follows:

56. Serious financial hardship in the context of a personal taxation debt of an individual taxpayer, such as income tax, is likely to ensue where payment of the disputed debt would place a taxpayer in a situation where there are insufficient assets, which could be reasonably realised to cover the gap between personal income and the expenses associated with the basic necessities of everyday life (emphasis added).

...

59. A finding of serious financial hardship is unlikely where the taxpayer or entities associated with the taxpayer hold assets such as term deposits, shares, investment properties, boats, or where there appears to be considerable scope for economising on items such as accommodation, clothes, education or general living or business expenses. Similarly, the mere anticipation of inconvenience or disruption to the taxpayer's business or personal lifestyle which could result from the reorganisation of the taxpayer's financial affairs to pay 50% of the disputed debt would not amount to hardship.

The Commissioner considers serious hardship for a person to be the deprivation of the basic necessities of everyday life, such as food, clothing, shelter or reasonable education.

According to PSLA 2011/4, there appears to be considerable scope for economising on items such as education or general living or business expenses.

No evidence of expenses and income has been provided so although this criterion is unable to be fully assessed we have considered the following.

The wording of your application states the company "wishes" to forgive the debt, subject to the Commissioner exercising his discretion. An unsigned Deed of Forgiveness was provided. Additionally, the Deed of Forgiveness contains Recital XX which stated that the debt forgiveness was subject to the Commissioner exercising his discretion under subsection 109G(4).

In contrast a signed Division 7A loan agreement was provided in support of the loan being placed onto complying terms.

Whilst it may be an administrative oversight it may also be evidence to show the Deed of Forgiveness was not actually executed and as such the debt was not forgiven. The wording of the application also indicates that an action has not yet been taken and is simply proposed subject to approval. If this were to be the case then the forgiveness would not occur in the specified income year and the sale of the property would be taken into account.

The property was sold for $XXX. Allowing for outgoings for the sale of the property such as agent and advertising fees and the repayment in full of the bank mortgage, it is estimated there may have been over $XXX in sale proceeds remaining. It is considered this amount would allow for the repayment of the debt owed to the company without causing undue hardship and still allow for the repayment of other debts and the purchase of a new affordable property.

It would also have been the case the property could have been sold at an earlier date and downsizing commenced into a cheaper property to allow for the repayment of debts without causing any undue hardship.

From the information available it is not accepted that repayment of the debt would have caused undue hardship.

b) when the entity incurred the debt, the entity had the capacity to pay the debt

In support of this criterion, you provided material of a specified earlier year to show you had the capacity to repay the debt when it was incurred.

Firstly, the material referred to above is at a time too early to show you had the capacity to repay a debt that wasn't incurred until a later time through a series of book transactions as a result of the transfer of the property from the company to you.

Moving on from the above point you have included rental income from the property and the corresponding negative gearing tax impacts as positive inflows to show you would have met the serviceability criteria for both the loan from the company and the refinanced bank mortgage.

However, in the relevant income years you have not reported any rental income nor were you entitled to receive any rental income.

The rental income you have included in the material provided was actually rental income received by the company from another entity. It is noted no rental agreement has been provided.

It is also noted that you moved into the property as soon as it was transferred into your name.

We have concluded the rental income was not in fact yours and you were never going to be in receipt of rental income from the property. As such the rental income and positive tax impacts should not have been included in the material to show that when you incurred the debt, you had the capacity to pay the debt from a specified year.

It is not accepted that you had the capacity to repay the debt when it was incurred and as such you fail to meet this criterion.

c) the entity lost the ability to pay the debt in the foreseeable future as a result of circumstances beyond its control

You stated the various factors greatly diminished your financial resources and income earning capabilities and reduced your financial capital and it meant you could no longer receive rental income from the property as you needed somewhere to live, and you no longer had the specified income earning capacity.

As we consider you did not have the capacity to pay the debt when it was first incurred it would naturally flow on that you cannot lose what you did not first have. As such this criterion has not been considered.

However, it would be noted that there was no specified income earning capacity when the debt was incurred. It is also noted you were never in receipt of rental income nor were you going to be in receipt of rental income from the property.

Conclusion

As per the reasoning above, it is concluded that the relevant criteria have not been met. Accordingly, subsection 109G(4) of the ITAA 1936 will not apply to treat any debt forgiveness by the company as not giving rise to a dividend.